Output gap nonsense in Italy: My new Intereconomics paper analyses how the European Commission's more and more pessimistic view concerning Italy's potential output has increased fiscal consolidation pressure and led to an economic 'doom loop'. A thread:
intereconomics.eu/contents/year/…
intereconomics.eu/contents/year/…
The Italian authorities were in open dispute over the Commission’s estimates of potential output in pre-COVID-19 times. In June 2019, the European Commission recommended the opening of an excessive deficit procedure (EDP) because of violations of the EU’s fiscal rules. /2
Although the political decision was against opening a new EDP for Italy, the technical debate remains unresolved. Italian authorities argued that the Commission was systematically underestimating the underutilization of economic resources in the Italian economy ('output gap'). /3
The European Commission’s potential output model is the core technical backbone of EU fiscal surveillance. Model-based estimates are used for evaluating and supervising member states’ fiscal performance and underlie recommendations related to medium-term budgetary objectives. /4
According to the estimates derived from this model, Italy’s economy was not suffering from underutilization of economic resources in pre-COVID-19 times: in Autumn 2019, the output gap (difference between actual and potential output) was estimated at -0.2% for the year 2019... /5
... meaning that the Italian economy operated nearly fully in line with its potential capacities – although the Italian unemployment rate in 2019 still stood at around 10% and inflation was below 1%. /6
Slow growth in the Italian economy over the ten years that preceded the COVID-19 shock had a strong impact on the Commission’s potential output estimates, as we observe downward revisions in several steps. /7
Before the start of the global financial crisis, the Commission estimated a steady growth trend in potential output. However, it then revised Italy’s official potential output estimates downwards in several steps as the country’s economic crisis deepened. /8
Based on this output gap assessment, the European Commission’s recommendations saw no fiscal space as the PO-model’s conceptual foundations suggested that expansionary fiscal policies would have risked an “overheating” Italian labor market. /9
If we extrapolate the pre-crisis trends in potential output, we find a large negative output gap of -16.9% of GDP for the year 2019, which starkly contrasts with the official Commission estimate of -0.2%. /10
Even when we assume that Italy’s potential output growth rate was cut by two thirds compared to the pre-crisis growth rate, which implies substantial hysteresis effects from 2010 onwards, the negative Italian output gap remains substantial (-8.5% of GDP). /11
We can demonstrate the relevance of output gap estimates for Italy by looking at implications for fiscal space according to EU fiscal rules. Given small official estimates of the output gap, the ‘structural’ deficit was estimated to be as large as the headline deficit. /12
This model-based estimation implied that the Italian government would not meet budgetary targets (max. ‘structural’ deficit of 0.5% of GDP). As a consequence, the Commission continued to demand “corrective” fiscal consolidation measures in the run-up to the COVID-19 pandemic. /13
However, Italy would have been running a large ‘structural’ fiscal surplus of 6.9% of GDP in 2019 if we simply extrapolate the pre-financial crisis potential output growth rates (implying an output gap of -16.9% of GDP). /14
Even under the hysteresis scenario, where post-crisis potential output growth was lower than in pre-financial-crisis times (but not negative, as suggested by the Commission’s official estimates), the ‘structural’ fiscal surplus in 2019 would have been 2.4% of GDP. /15
Alternative estimates of the output gap pointing to a higher degree of resource underutilization would have reduced the fiscal consolidation pressure on the Italian government in pre-COVID-19 times. /16
The Italian state would have overachieved its medium-term budgetary target, and the Commission’s recommendation for lower government expenditure growth in the face of an officially small output gap would have been obsolete. /17
The "flexibility" guidelines in the EU's fiscal rules introduced in 2014 establish a direct link between the size of the output gap and the required fiscal adjustment effort. In the case of a larger output gap, little or no fiscal adjustment is required. /18
This step of introducing “flexibility” may have led to additional leeway in political case-by-case assessment. Paradoxically, however, it has further increased the relevance of the estimates with the European Commission’s model, and thus the importance of technical details. /19
As a consequence, it would have mattered a great deal in the years prior to the COVID-19 shock if the negative output gap had been estimated to be larger than 4% of GDP in Italy, because this would have pointed to the need of stopping further fiscal consolidation. /20
Italy's fiscal consolidation over the last years caused hysteresis, leading to successive rounds of downward revisions in potential output that validated the original pessimistic potential output forecasts and caused further fiscal consolidation requirements - a doom loop /21
Once the clauses that currently exempt the ‘structural’ deficit limits from being applied are lifted, a pessimistic view on potential output will again systematically restrict the fiscal space that is available to Italian policymakers when it comes to supporting the recovery. /22
In the context of the Corona crisis, avoiding pro-cyclical fiscal tightening in Italy and other countries that would halt the economic recovery will require that policymakers’ hands are not tied by overly pessimistic views on potential output. /end
